1. © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 1 Cost Management Measuring, Monitoring, and Motivating Performance Chapter 7 Activity-Based Costing and Management

2. © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 2 Chapter 7: Activity-Based Costing and Management Learning objectives Q1: What is activity-based costing (ABC)? Q2: What are activities and how are they identified? Q3: What process is used to assign costs in an ABC system? Q5: What are GPK and RCA? Q4: What is activity-based management? Q6: How does information from ABC, GPK, and RCA affect managers’ incentives and decisions?

3. © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 3 Q1: Activity-Based Costing (ABC) ABC is a method of cost system refinement. Indirect costs are divided into “sub-pools” of costs of activities. Activity costs are then allocated to the final cost objects using a cost allocation base (more commonly called cost drivers in ABC). Activities are measurable, making it more likely that cost drivers can be found so that a final cost object will absorb indirect costs in proportion to its use of the activity.

4. © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 4 Q1: Traditional Costing vs. ABC Product A Product B Product C Traditional costing systems: Indirect Costs Direct Costs Direct costs are traced to the individual products. The individual products are the final cost objects. Indirect costs are grouped into one (or a small number) of cost pools; a cost allocation base assigns costs to the individual products

5. Q1: Traditional Costing Systems © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 5

6. © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 6 Q1: Traditional Costing vs. ABC Activity-based costing systems: Indirect Costs Product A Product B Product C Direct Costs The individual products are the final cost objects & direct costs are traced to the individual products. Indirect costs are assigned (traced & allocated) to various pools of activity costs. Activity 1 Activity 2 Activity 3 Activity costs are allocated to products

7. Q1: ABC Costing Systems © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 7

8. © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 8 Q2: What are Activities and How are They Identified? The ABC cost hierarchy includes the following activities: organization-sustaining – associated with overall organization facility-sustaining – associated with single manufacturing plant or service facility customer-sustaining – associated with a single customer product-sustaining – associated with product lien or single product batch-level – associated with each batch of product unit-level – associated with each unit produced

9. © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 9 Q2: ABC Cost Hierarchy Example Some of the costs incurred by the Dewey Chargem law firm are listed below. This firm specializes in immigration issues and family law. For each cost, identify whether the cost most likely relates to a(n) (1) organiz-ation- sustaining, (2) facility-sustaining, (3) customer-sustaining, (4) product- sustaining, (5) batch-level, or (6) unit-level activity and explain your choice.

10. © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 10 Q3: What Process is Used to Assign Costs in an ABC system? 1.Identify the relevant cost object. 2.Identify activities and group homogeneous activities. 3.Assign costs to the activity cost pools. 4.Choose a cost driver for each activity cost pool. 5.Calculate an allocation rate for each activity cost pool. 6.Allocate activity costs to the final cost object.

11. © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 11 Q3: How Are Cost Drivers Selected for Activities? For each activity, determine its place in the ABC cost hierarchy. Look for drivers that have a good cause-and-effect relationship with the activities’ costs. Use a reasonable driver when there is no cause-and-effect relationship.

12. © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 12 Q3: ABC in Manufacturing Example Alphabet Co. makes products A & B. Product A is a low-volume specialty item and B is a high-volume item. Estimated factory- wide overhead is $800,000, and the number of DL hours for the year is estimated to be 50,000 hours. DL costs are $10/hour. Each product uses 2 DL hours. Compute the traditional cost of each product if Products A & B use $25 and $10 in direct materials, respectively. First, compute the estimated overhead rate: Estimated overhead rate = $800,000/50,000 hours = $16/hour. Product AProduct B Direct materials$25$10 Direct labor (2hrs @ $10)2020 Overhead (2 hrs @ $16)3232 $77$62

13. © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 13 Q3: ABC in Manufacturing Example Alphabet Co. is implementing an ABC system. It estimated the costs and activity levels for the upcoming year shown below. First, compute the estimated overhead rate for each activity:

14. © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 14 Q3: ABC in Manufacturing Example

15. © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 15 Q3: ABC in Manufacturing Example Alphabet recently completed a batch of 100 As and a batch of 100 Bs. Direct material and labor costs were as budgeted. Information about each batch’s use of the cost drivers is given below. Compute the overhead allocated to each unit of A and B.

16. © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 16 Q3: ABC in Manufacturing Example Compute the total cost of each product and compare it to the costs computed under traditional costing. Traditional costing assigned $77 to a unit of Product A and $62 to a unit of Product B. The only difference between the two costing systems is that Product A is assigned more overhead costs under ABC. The additional overhead assigned to Product A reflects Product A’s consumption of resources.

17. © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 17 ABM is the process of using ABC information to evaluate opportunities for improvements in an organization. Q4: Activity-Based Management (ABM) Examples include managing & monitoring customer profitability product and process design environmental costs quality constrained resources

18. © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 18 Activities can be defined so that different costs of servicing customers are accumulated. Q4: ABM & Customer Profitability Examples include analyzing the types of bank transactions used by various categories of customers comparing the costs of servicing insurance contracts sold to married versus single individuals comparing the costs of different distribution channels

19. © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 19 Activities can be defined so that the costs of stages of production or of a business process are accumulated. Q4: ABM & Product/Process Improvements Examples include determining the costs of non-value-added activities so the most costly can be reduced or eliminated changing the steps in the accounts payable function to reduce the number of personnel determining the most costly stages of product development so that the time to market is reduced

20. © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 20 Activities can be defined so that types of environmental costs are accumulated. Q4: ABM & Environmental Costs Examples include capturing the costs of contingent liabilities for waste disposal site remediation comparing the cost of recycling packaging to the cost of disposal computing the costs of treating different kinds of emissions

21. © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 21 Activities can be defined so that categories of costs of managing quality are accumulated. Q4: ABM & Quality Costs Common categories of quality costs are costs of prevention activities costs of appraisal activities costs of production activities costs of postsales activities

22. Q5: What are GPK and RCA? Costing approaches similar to ABC because they involve multiple pools and multiple drivers GPK can be described as marginal planning and cost accounting –Each cost is traced to a cost center (smaller than a department) which performs a single repetitive activity, and is the responsibility of one manager) –Output measures tracks the volume of resource use –Costs are segregated into proportional (change with volume in resource use) and fixed –Practical capacity is used for estimated allocation rate volumes © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 22

23. Q5: Capacity Definitions Theoretical capacity – maximum assuming continuous, uninterrupted operations 365 days/year Practical capacity – typical operating conditions Budgeted capacity – expected volume for the upcoming time period Idle/excess capacity – difference between activity capacity used and one of the above measures of capacity © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 23

24. Resource Consumption Accounting (RCA) Builds on GPK and ABC principles Each cost is assigned to a resource cost pool –Labor and machinery are often placed in different cost pools since they are different types of resources –RCA involves a significantly larger number of cost pools than traditional accounting –Like GPK, segregates proportional and fixed costs –Utilizes theoretical rather than practical capacity for allocating fixed costs More likely to focus manager attention on reducing idle and non- productive resource time © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 24 Q5: What are GPK and RCA?

25. Q5: Benefits/Drawbacks to GPK/RCA Benefits –Generates multi-level internal income statements useful for short terms decisions because it focuses on marginal cost –Increases cause & effect awareness among managers –Categorizes costs (and generates profit margin) at the product, product group, division, and company level –Avoids arbitrary allocations of fixed costs Drawbacks –Can be costly to implement –Can result in a large number of variances to analyze © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 25

26. Q5: Comparison of ABC, GPK, and RCA ABCGPKRCA Character of cost accounting system Full costingMarginal costingFull and marginal costing Location of dataDatabase separate from general ledger Comprehensive accounting system Primary decision relevance Mid- to long-termShort-termShort-, Mid-, and Long term Allocation of overhead based on ActivitiesCost CentersResources and/or activities Cost DriversActivity –BasedResource Output related Resource output or activity related Fixed cost allocation rate denominator Actual, budgeted, or practical capacity Budgeted or practical capacity Theoretical capacity © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 26

27. © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 27 Benefits more accurate and relevant product cost information employees focus attention on activities measurement of the costs of activities and business processes identify non-value-added activities and reduce costs Q6: Decision Making with ABC, GPK, and RCA Costs systems can be difficult to design and maintain more information must be captured decision makers may not use the information appropriately

28. © John Wiley & Sons, 2011 Chapter 7: Activity-Based Costing and Management Eldenburg & Wolcott’s Cost Management, 2eSlide # 28 Judgment is required when determining activities. Q6: Uncertainties in ABC and ABM Implementation Judgment is required when selecting cost drivers. Denominator levels for cost drivers are estimates. ABC information includes unitized fixed costs, so decision makers must use ABC information correctly.